Emissions Taxation in Durable Goods Oligopoly Author(S): Gregory E

Emissions Taxation in Durable Goods Oligopoly Author(s): Gregory E. Goering and John R. Boyce Source: The Journal of Industrial Economics, Vol. 47, No. 1 (Mar., 1999), pp. 125-143 Published by: Blackwell Publishing Stable URL: http://www.jstor.org/stable/117510 . Accessed: 05/07/2011 18:26 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at . http://www.jstor.org/action/showPublisher?publisherCode=black. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. Blackwell Publishing is collaborating with JSTOR to digitize, preserve and extend access to The Journal of Industrial Economics. http://www.jstor.org THE JOURNAL OF INDUSTRIALECONOMICS 0022-1821 VolumeXLVII March1999 No. 1 EMISSIONS TAXATION IN DURABLE GOODS OLIGOPOLY* GREGORY E. GOERINGt AND JOHN R. BOYCE: This paper examines the use of taxation to control external damage due to pollution when productdurability is endogenouslydetermined. A special form of the emissions function is also examined which is equivalentto an excise tax on output. The model indicatesthat many conventionalresults in the durabilityand taxationliterature need not hold when durabilityis endogenouslydetermined. The analysis shows durabilitymay not be independentof industrystructure nor will firms minimizetheir manufacturingcosts of providingservice. In addition, the second-besttax on imperfectlycompetitive firms is not necessarily less than the tax on a competitivefirm with endogenousdurability. I. INTRODUCTION MANY STUDIEShave examined the impact of taxation on a firm's output choice. In particular, the use of taxes to mitigate and control externalities (such as pollution) in imperfectly competitive environments has received considerable attention in the past several decades. For example, Buchanan [1969], Barnett [1980], and Innes et al. [1991] examine the second-best tax on monopolistic firms that generate externalities. They conclude that the optimal tax on a monopolist is less than that on a competitive firm since the monopolist restricts output, implying that the market power distortion works in the opposite direction of the negative externality distortion. Other authors, such as Levin [1985], show that the optimal tax in oligopolistic markets is even more complicated than in monopolistic markets due to firm asymmetries and strategic behavior. However, these studies have ignored the fact that firms have other variables under their control such as the durability or quality of their product. There is evidence that this is an important omission. For example, Asch and Seneca [1976] found that many of the most heavily polluting industries in the US are both highly concentrated and manu- * The authors gratefully acknowledge the helpful comments of two anonymous referees as well as those of Professor Severin Borenstein, the North American Editor. Of course any remaining errors are solely the authors' responsibility. t Authors' affiliation: Gregory E. Goering, Department of Economics, University of Alaska Fairbanks, Fairbanks, AK 99775-6080, USA. email: ffgeg@uaf: edu tJohn R. Boyce, Department of Economics, University of Auckland, Private Bag 92019, Auckland, New Zealand. email: j. [email protected] ? Blackwell Publishers Ltd. 1999, 108 Cowley Road, Oxford OX4 IJF, UK, and 350 Main Street, Maiden, MA 02148, USA. 125 126 GREGORY E. GOERING AND JOHN R. BOYCE facture durable products. Examples include the aircraft, automobile, steel and refrigeration industries, which all manufacture durable products and have relatively large pollution abatement expenditures. The influence of emissions taxation on the durability of the firm's product, as well as the optimal second-best tax when durability is endogenously determined has not received much attention in the literature. This paper develops and analyzes a game theoretic model of product durability and emissions taxes. An infinite horizon oligopoly model is developed where the firms, as a byproduct of manufacturing durable goods, produce environmental pollutants which are taxed. The firms' emissions are assumed to be a function of both the durability of their output and the number of units they produce in each period. We also examine two special forms of the emissions tax function where the tax depends only upon output. An extreme version of this is a per unit sales or an excise tax. The results indicate that many of the conventional results in both the durability choice and taxation literature fail to hold. When durability is included, there are three possible sources of market failure: 1) over-production due to a pollution externality; 2) under- production due to market power; and 3) in-appropriate durability levels (e.g., planned obsolescence) due to producers choosing a durability which does not minimize the social costs of providing a given service level. Buchanan's [1969] paper and much of the subsequent optimal taxation literature has focused on the first two externalities. Coase [1972] and much of the subsequent durability literature focused on the third. We combine all three possible market failures into a positive model of firm response to taxation and consider the normative implications for optimal taxation in a second-best world. In terms of the durability results, the model shows that durability will not generally be independent of the number of firms (market structure) when emissions taxes are in place. This is in contrast to Swan's [1970, 1971] conclusion that the firm's durability choice is independent of market structure.1 Furthermore, the failure of the independence result is shown to occur even in rental markets which contrasts with Swan's [1981] and Raviv and Zemel's [1977] finding that taxation, in particular a corporate income tax, only upsets the independence result if a monopsonistic producer's output is sold. The reason for this difference in results stems from the fact that emissions or excise taxes depend on the level of output, 1 Swan's result has spawned a large body of literature examining the conditions required for independence. Kamien and Schwartz [1974], for example, argue that a monopolist may produce a less durable good than a pure competitor given the monopolist is restricted to only one plant (see, however, Swan's [1977] comment on their finding). In general, rental markets and constant returns to scale are sufficient for independence. See Schmalensee [1979] for a review of the early durability literature and Goering [1992, 1993] for an examination of the independence result in oligopoly markets and with learning economies. ? Blackwell Publishers Ltd. 1999. EMISSIONS TAXATION IN DURABLE GOODS OLIGOPOLY 127 thus affecting marginal production decisions, whereas profit taxes do not affect marginal production decisions. In addition, since firms minimize the sum of pure production costs plus emission tax costs, we show that if emissions are a function only of output (not durability), an emissions tax will induce a renting firm to lower its periodic output and increase product durability.2 By doing so a renting firm can provide the same service flow at a lower total cost (manufacturing plus emissions tax costs). In terms of taxation, we show that the second-best optimal tax on imperfectly competitive firms is not necessarily less than the tax on a competitive firm. This is in contrast to the conventional wisdom that the tax on an imperfectly competitive firm, such as a monopolist, is necessarily less than a competitive firm due to the distortion (reduction) of market output levels. This unconventional result is due to the fact that an imperfectly competitive firm's durability choice is influenced by the tax. Depending upon the cost of durability at the margin and the form of the emission and demand functions this distortion may move the firm closer to the socially optimal durability or farther away from it. In particular, if the durability cost function exhibits increasing returns, demand is linear and the survival function for durability is linear in durability choice, then the optimal tax on an oligopolistic or monopolistic market may be greater than that placed on a competitive industry when durability is endogenous. II. THE BASIC OLIGOPOLY DURABILITY MODEL Suppose that the durable goods industry of interest is comprised of n producers.3 At each instant these producers select the durability or quality of their product and the number of units to manufacture. Thus firm i chooses a durability 6b(t) and output level qi(t). The stock of available goods for use by firm i at any time t is then given by (cf. Muller and Peles [1990]): (1) Qi(t) = j 0[t - s, (s)]q(s)ds + Q(T), 2 Any tax on output alone has this property. 3 Note that the number of firms n is parametrically specified. This parametric specification along with other simplifications outlined below allows us to examine the influence of market structure (i.e., number of firms in the market) on the firm's long-run durability choice under taxation. This parametric approach, among other things, has the disadvantage of implicitly ruling out entry (or exit) in the industry even in the long-run. However, we conduct comparative statics exercises on the effect the number of firms has on the industry.

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